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House Tax Bill’s Changes to State and Local Tax Deductions Would Hurt States

BY

The House tax bill released today ends the federal deduction for state and local income and sales taxes and limits the deduction for state and local property taxes to taxes under $10,000 — all to pay for marginal income-tax rate cuts. That would be a bad deal for most Americans. It would likely harm state budgets nearly as much in the coming years as full repeal of state and local tax deductions, would likely shift more of the load for paying state and local taxes from high-income people to low- and middle-income families, and would fall much harder on some states than others. The proposal also probably would hurt local government budgets over time because states would likely shift costs to localities and because in some states such as New Jersey and New York a sizeable share of taxpayers pay more than $10,000 in local property taxes.

Property taxes are almost all levied by local governments and aren’t a major source of revenue for states, while income and general sales taxes are the two main sources of state tax revenue. Property taxes account for only 2 percent of state tax revenue nationally, while income and sales taxes account for 37 percent and 31 percent, respectively.

So for state budgets, which fund education, health care, transportation, and other services, it’s the deduction for income and sales taxes, which the House tax bill would end, that really matters. (Currently, taxpayers can deduct either their state and local income taxes or their state and local general sales taxes, whichever are higher. In all 42 states with an income tax, many more filers deduct their income taxes than sales taxes.) As we’ve explained, the deduction makes higher-income filers more willing to support state taxes, because they can reduce the federal taxes that they owe by deducting these state taxes. Repealing the deduction would make it harder for states — many of which already face serious budget strains — to raise sufficient revenues in the coming years to invest in high-quality education, infrastructure, and other priorities crucial to the nation’s long-term economic prospects.

Repealing the income tax deduction would be particularly harmful to state budgets because state income tax revenues tend to grow with the economy, while other major state revenue sources such as sales and excise taxes do not. By reducing support for state income taxes, particularly among high-income taxpayers — a group that tends to be politically influential in states — eliminating the deduction would encourage states to lean more heavily on weaker revenue sources, likely leading to cuts over time in funding for education and other public priorities. Also, state borrowing costs could rise as bond rating agencies react to states’ reduced capacity to generate adequate revenue, raising the cost of needed infrastructure projects.

Further, eliminating the income tax deduction would, over time, likely lead to a shift in who pays state and local taxes even further away from high-income residents to those with middle and lower incomes. That’s because state income taxes are the only major state and local revenue source that’s based on ability to pay, with tax rates in most states rising with income.

States with income taxes and high average incomes would be the hardest hit. They include Maryland, Connecticut, New Jersey, Massachusetts, Virginia, and Oregon, where more than a third of filers claim the deduction, as well as California and New York, where taxpayers in 2015 deducted $80 billion and $52 billion in state and local income tax payments, respectively. But states without income taxes would also be affected. In Chairman Brady’s home state of Texas, which lacks an income tax, over 2 million households — 18 percent of all filers — deducted about $4.8 billion in state and local sales taxes in 2015. They could no longer do so under the House bill.

Retaining the property tax deduction for property taxes under $10,000 might initially protect local governments in most states from significant additional budget pressures, but only temporarily. First, if they can’t deduct state and local income taxes, some taxpayers would no longer be able to itemize their deductions and, therefore, wouldn’t be able to deduct their property taxes. Second, facing greater challenges raising revenue, states likely would reduce, over time, support for local governments. (States provide 28 percent of local government revenue, including funding for school districts.) That reduced support would, in turn, force local governments to either accept less funding for schools, parks, libraries, community health centers, and other services, or raise local taxes, including property taxes, to make up the difference. These challenges would add to the strain on their budgets in coming years, a period that already may be particularly challenging in part because the White House and congressional Republicans are considering shifting significant new costs to states and localities.

Further, in some states a sizeable share of taxpayers pay more in property taxes than the $10,000 limit the House bill would establish. In New Jersey, the average property tax deduction was nearly $9,500 in 2015, and in New York it was over $8,700. About 30 percent of New Jersey homeowners pay property taxes over the $10,000 limit, as do nearly one-fifth of New York homeowners, according to Census data for 2016. Other states with relatively high shares of homeowners over the limit include most of the New England states, California, Illinois, and Texas. For taxpayers over the limit, the deduction’s value would fall, reducing support for local property taxes and adding further to the pressure over time on local government finances.

To be sure, eliminating the deduction for state and local income taxes and capping the property tax deduction would make the federal income tax more progressive. But that ignores the actual tradeoff that the House GOP tax plan proposes, which is to use the revenue to pay for marginal income-tax rate cuts, which are more tilted to the top than the state and local tax deductions. Middle- and low-income people would see little benefit from the overall tax plan, but they would bear much of the brunt of the harm that’s likely to be done at the state and local levels. That’s a bad deal for most of us.